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Bad Investments

Imagine a fictitious company called PINKO. PINKO bills itself as a "business consulting firm which helps its clients solve complex byproduct transportation and disposal issues." In other words, cities and companies pay PINKO to help them find places to dump their garbage and industrial waste. Not a very sexy business.

And not a very profitable one. In several years of operations, PINKO lost millions of dollars wining and dining potential clients and building a fancy corporate headquarters. They didn’t generate much revenue but the new corporate "campus" was beautiful.

Eventually the banks refused to loan PINKO any more money. So PINKO’s directors decided to share their good fortune by taking their company public.

There was no way PINKO could meet the standards for a formal IPO on the NASDAQ. No respectable Wall Street firm would touch them.

PINKO had their lawyers file the necessary papers to trade "over the counter" on the OTC Bulletin Board instead. PINKO stock was born at $5 per share, with 5 million shares publicly traded "in the float" and another 10 million shares held by company insiders. The Market Makers – NASDAQ firms that buy and sell stocks to "maintain a market" for a company – were small operators in regional centers far from Wall Street.

Fast forward to two years later – PINKO had fallen to $1.25 per share. Heavy cash burn (spending a lot without generating any real cash earnings) left the company with less than a million bucks in the bank. Without new financing, PINKO would have to close its doors by the end of the next fiscal quarter.

A generous company options plan had already increased the outstanding shares to 18 million with 8 million in the float. Most insiders exercised their options to buy shares at .10 and sold for $2-3 as soon as they could. Company insiders took home more than $6 million while the company they managed was losing money.

This is where the real fun begins. First PINKO management spoke discreetly with some professional "financiers" based in the Cayman Islands, who offered PINKO $10 million in financing in return for "discount convertible" stock payable in six months, and a hefty interest rate in the meantime. If the price of PINKO stock went down, the financiers would get even more shares to convert and sell.

The press release announcing the new financing was extremely vague about the discount convertible aspects of the deal. It was PINKO’s next press release that really grabbed everyone’s attention.

"PINKO.COM ANNOUNCES PROPRIETARY SYSTEM TO MANAGE CIVIC WASTE DISPOSAL OVER THE INTERNET". PINKO announced an "interactive database and inter-government communications program aimed at helping communities cope with the growing solid waste challenge in America."

PINKO stock rose from $1.25 to $2.50 the next day. An obscure "investor relations" firm issued an "investment opinion" rating PINKO a Strong Buy with a 12-month price target of $10 based on their "innovative, groundbreaking use of the Internet to link thousands of local governments with waste disposal problems." Under new regulations, the IR firm had to disclose that PINKO had paid them 100,000 shares of stock for their services, plus another 100,000 warrants.

Stock chat boards all over the Internet buzzed all day and most of the night about PINKO’s future chances.

One of the posters who noticed the PINKO excitement went by the name of "NewKid". He was actually not a kid any longer, with a job, two kids of his own, a mortgage and a 1988 Oldsmobile Cutlass which badly needed a $1200 engine job to avoid ending up in the sPINKO yard.

NewKid hadn’t been trading for very long. Some of his buddies at the office kept talking about making lots of money in the stock market, so he took his limited savings and opened an online brokerage account. So far, he had done OK with tips from Internet chat boards. He couldn’t "afford" the expensive stocks so he mostly looked for companies under $5.

NewKid would hold a stock for a few days and try to sell for a small profit. He seemed to lose money as often as he made it, but he remained optimistic.

NewKid liked what he saw about PINKO. The company was described as a leader in the waste management field – NewKid was an accountant who hated taking his trash to the curb and didn’t know anything about the waste management industry.

But he also received an E-mail from a free Web site he subscribed to, MoonShotStocks!, saying that PINKO would be a big gainer for people who got in soon.

One busy poster with the clever moniker "PINKOMan" kept talking about a "secret, illegal short position" which several "crooked Market Makers" would have to cover when PINKO’s Internet system took off and they finally got a NASDAQ listing. "Naked" shorts occur when a Market Maker or trader sells stock that they haven’t actually borrowed from someone else first.

PINKOMan claimed that was the only reason PINKO had gone from $5 to $1.25, "evil naked shorts."

Between the Internet announcement and a clear short squeeze on the horizon, NewKid felt lucky to buy 2000 shares at $4.50.

He was even happier when PINKO opened at $6 (that’s a $3000 profit!) the next day and ran as high as 7 ½ ($6000 ahead now!). The sudden drop back to $5 took NewKid by surprise, but PINKOMan and some other posters on the PINKO thread had warned everyone about a "shakeout." The same crooked Market Makers would try to grab cheap shares to cover their growing short position.

No way NewKid was going to fall for that old trick. He was still $1500 ahead by market close, with PINKO at 5 ¼.

PINKO traded 12 million shares that day. "Institutional buying," PINKOMan cooed. "Wait until the NASDAQ listing is public. I won’t sell until PINKO hits $50!" Volume the day before was 3 million shares, still more than 20 times higher than the 125,000 daily average PINKO had seen for the past year.

PINKOMan also posted an E-mail that looked like it came from the PINKO CEO. The CEO promised a "nationwide system rollout" in the very near future and a "quick application for a NASDAQ listing." NewKid went to bed happy.

The next day, NewKid was tied up in meetings all morning so he didn’t check PINKO’s share price until almost lunchtime - $2.50! PINKO had opened at 4 5/8, down 5/8. From there it went straight down.

NewKid frantically skimmed the hundreds of new messages on the PINKO thread but no one seemed to know what had happened. NewKid only knew he was down $4000 and couldn’t decide whether to hold or sell at a loss.

Someone said he should have used a "stop loss" order, but he didn’t know what that was. Anyway, PINKOMan said that the posters knocking PINKO’s new Internet system were paid shills, sent by the illegal shorters to knock the company and hold down the share price until they could cover.

PINKOMan said that all the PINKO longs should "call their certs" to stop the shorts. Taking delivery of an actual stock certificate means the shares can’t be borrowed by someone taking a legitimate short position in a stock.

NewKid was too confused to think about "calling his certs." He kept thinking about the engine job for the Cutlass and how he would pay for it now.

Let’s take a closer look at what really happened to NewKid’s big play in PINKO.

Legitimate companies can raise money all sorts of ways. They can sell shares to private investors at a fixed price, get a bank loan or even sell bonds if a reputable firm will underwrite the issue. Only PINKOpy little companies resort to discount convertible financing. Many never survive the consequences.

The convertible holders in PINKO’s case knew they would get at least 10 million shares for their $10 million investment. The agreement came with a 20% discount built in (the convertible holders would get 10 million shares at $1 if the market price was $1.25).

If the price dropped below $1.25, say $1, they would get 12.5 million shares at .80. The 20% profit is guaranteed up front. But what’s the difference if PINKO has to repay $10 million regardless?

A lot for shareholders like NewKid whose shares are worth less and less as PINKO issues more new shares. An extra 2.5 million shares would be more than 10% of the total outstanding. And the convertible deal was going to dilute current shareholders more than 50% already (from 18 million shares outstanding to 28 million shares).

On top of that, the convertible "investors" had no intention of selling their shares that cheaply anyway. NewKid was about to get nailed in the discount convertible financing racket.

Once the Internet news came out on PINKO, the convertible holders called up their offshore brokers in the Caymans and had them start shorting PINKO as fast as they could. Ordinary retail traders in the US usually can’t short a BB stock. But that limitation doesn’t apply to offshore operations.

The brokers knew that the discount convertible firm would get at least 10 million shares from PINKO for their original investment (which they would use to cover their short position). So they shorted several million shares "naked" at prices ranging from $4 to $7.50. The brokers never bothered trying to borrow the shares from somewhere else. Which is good – because the shares didn’t exist yet.

As for PINKOMan’s exhortation to "call your certs," it wouldn’t have made any difference to the Cayman Islands shorters. They were shorting against their discount convertible shares, not existing shares.

The proceeds from the short sales went straight into the convertible holders’ accounts. Instant profit before the conversion ever took place. Imagine a business where you can put up $10 million and take home $30 million just a few months later – and still have half your investment left to redeem.

No one knows exactly how many shares are shorted this way. Offshore firms cannot be held accountable by the SEC, only US-registered companies.

The other "illegal short position" that PINKOMan hyped on the chat thread probably never existed. If it did, NewKid could not have verified that either. Only company officials can get the actual trading reports for their stock.

The "transfer agent," who keeps track of who holds the outstanding shares, will confirm only how many shares of a company are supposed to be trading. The "TA" wouldn’t notice the extra shares until the next monthly report.

And it’s not illegal for Market Makers to short "naked" anyway. In fact, it’s part of their job.

When PINKO took off and orders to buy millions of shares flooded in, the MM’s didn’t have that much PINKO stock in their inventory to sell. To continue "making a market" they sold shares they didn’t have and ended up in a net short position.

That is why PINKO suddenly pulled back from $7.50 to $5. Daytraders started to take profits over $7. The buy orders dried up as traders sold their PINKO shares. The MM’s dropped the bid as fast as they could to buy back cheap shares (under $7) compared to where they had already sold them.

One trader I know calls this high-volume blow-off top "spinning," like a washing machine in a spin cycle.

NewKid was caught in a crossfire. The convertible holders were dumping millions of new shares into the market, shares which he didn’t know existed. And the convertible holders would sell for any price they could get. Anything over $1 was pure profit.

Needless to say, companies that resort to convertible financing stand little chance of sustaining the minimum bid (usually $4) required to get a listing on the formal NASDAQ exchange. The convertible holders will destroy the share price as they short as many shares as possible.

Once PINKO’s share price went under $1.25, the convertible holders could short even more because they knew they would get more shares. They kept driving down the price until they sucked the last drop of blood out of PINKO shares.

Shorting a million shares at $1 and replacing them with shares bought at .80 is still a cool $200,000 profit. Tax-free in offshore havens like the Cayman Islands.

NewKid also made a big mistake believing the Internet story in the PINKO press release. Companies with rotten track records almost always continue to be rotten companies with rotten management, no matter what business they are in. Any group which hasn’t turned a profit after several years in business doesn’t deserve your investment dollars.

In PINKO’s case, the whole Internet system was a fraud to begin with. PINKO had a database of dumpsites around the country and started to use E-mail to stay in touch with city governments about their waste disposal needs. Whenever PINKO managed to connect a dump with space and a city that needed extra waste disposal capacity, it was a sale for the PINKO.COM "system".

Beware of new "systems" with low barriers to entry (i.e. anyone can easily copy their business and compete). They are the opposite of "incredible gizmos" like instant cures for cancer and AIDS, or perpetual motion machines.

PINKO’s competitors were already using the Internet to link up customers and dumpsites; they just hadn’t thought about touting it in a press release.

Most established companies already have an in-house Investor Relations department. They don’t pay outside firms with cheap stock to tout the company on Internet chat boards. They also don’t need to hype up their share price for the benefit of offshore financiers.

Finally, NewKid believed the myth that anyone who "bashed" PINKO on the Internet was a tool of the "evil shorts" with the "illegal naked short position." Most US traders can’t short Bulletin Board stocks to begin with, and those who can rarely bother shorting stocks under $3. The professional shorters I know won’t touch ‘em until they run up, like PINKO did to $7 after it traded near a buck for a long time.

"Penny" stocks like PINKO go down because no one wants to buy a lousy business with management that loses money year after year. The "illegal short position" is usually a figment of a hypester’s vivid imagination. It happens to sound good to naïve investors like NewKid.

BB stock hypesters like PINKOMan are the real villains in this story. Without them, newbies like NewKid probably won’t get sucked into buying stocks like PINKO. They certainly won’t hang on while their profits turn into losses amidst the chaos and confusion that always follows the first big press release.

When a hypester says that heavy volume in a BB stock is institutional buying, he is lying, pure and simple. Most funds aren’t allowed to buy stocks under $10, much less BB stocks trading under $5 like PINKO. The big blocks you see when stocks like PINKO are "in play" are usually insiders and convertible holders shorting all they can into the heavy daytrading volume.

Was PINKOMan a paid hypester for PINKO? The only way NewKid could find out would be to sue "PINKOMan" and get the online service to divulge his real identity. But NewKid didn’t have the money for a lawsuit like that.

If you are long a BB stock and someone shows up who says "Look at the press release, they just got $10 million in discount convertible financing!" you should listen. Check the SEC filings (if they exist) and get an accurate picture of the company. If the company doesn’t file with the SEC, sell your shares and run like hell.

If a "naysayer" points out that existing company management hasn’t sold anything except stock for several years, take a step back and think about it. Would you buy a company that never makes money? Probably not. So don’t buy stock in a company that does unless you have a very clear plan to sell quickly for a profit.

All of these gimmicks are designed to make you want to BELIEVE in the hype. If the story sounds too good to be true and the guy making the offer is someone you would cross the street to avoid, save yourself some anxiety and some money. Move on to the next stock.

Go find a decent company with SEC filings and buy some shares. You may not get rich overnight buy you will sleep better.

Epilogue: PINKO was delisted six months after NewKid sold his shares at a $5000 loss. NewKid closed his online trading account and took a second job. The PINKO CEO left the company shortly before it went bankrupt. He moved to the Cayman Islands, where his new partners in the venture capital firm he joined helped him settle in to a comfortable new lifestyle. He never liked the smell of landfills anyway. And the weather was a lot warmer than Hoboken.

Any resemblance with actual stocks currently trading on the OTC: BB is purely coincidental. Uncanny, perhaps, but coincidental.